Imagine if you could turn your favorite leisure activity into a successful business venture. Many Americans are now turning to what they love to earn income, whether it’s enough to quit their day job or just a fun way to cover the costs.
If you are passionate about a craft or other activity, your money-making opportunities are virtually endless these days. Here are some things to consider as you turn your hobby into cash.
Hobby Versus Business
To turn an activity into a business, you don’t need to reach a certain level of sales or income. To have a business, all you really need is a reasonable expectation that you’ll make a profit from the activity.
As far as the IRS is concerned, you are supposed to report income “from whatever source derived.” This means that whether you consider something a hobby or a business, if you are making money, you need to report it on your tax return.
So the hobby versus business question boils down to how you handle your expenses and what to do if your activity loses money. For example, let’s say you sell hand-knitted goods in your spare time. If you actually lose money from this activity, when you factor in all the related expenses like yarn and marketing, the IRS will let you deduct this loss to offset your other income (i.e. your day job), if your knitting is considered a business. You cannot deduct a loss, if it’s a hobby.
What Qualifies as a Business?
According to the IRS, an activity is a “business” if it has made a profit in three of the past five years. Until you have five years under your belt, the IRS will look to see if you’re taking the activity seriously and treating it like a business with the primary goal of making a profit. For example,
- Do you keep financial records for your business?
- Do you have a separate bank account for your business?
- Do you have a business name?
- Do you invest in advertising and marketing?
If you are interested in learning more about how the IRS determines a profit motive for a business, you can read the IRS article “Is your hobby a for-profit endeavor?”
Start Treating Your Hobby Like a Business
When you’re ready to move your activity beyond a fun pastime, you need to get serious about managing it. For example, you’ll need a bookkeeping system to log income and expenses. You’ll need a business checking account, and possibly a credit card. In addition, you may want to create a separate legal entity, such as a corporation or LLC.
Here are five key steps toward launching an official business:
1. Pick a Business Name
Your business name marks the beginning of your new brand. You’ll want to choose something that’s easy to remember and reflects what your hobby is all about. In addition to checking if the website address for your name is available, you’ll need to make sure that another business isn’t already using the name.
First, you should perform a free business name search to make sure your proposed name is available in your state. If it is available, you can take your search to the next level with a free trademark search to check if anyone has filed a trademark for your name.
2. Register Your Business
If you incorporate or form an LLC (Limited Liability Company) for your business, your personal assets are shielded from creditor claims against the business. In addition, formalizing your activity as a corporation or LLC helps show the IRS you are serious about the business.
If you prefer not to form an LLC or corporation, you can register your business name with the state via a DBA (Doing Business As) filing, also known as a Fictitious Business Name.
3. Get a Federal Tax ID Number
To distinguish your business as a separate legal entity, you’ll need a Federal Tax Identification Number (which is also called an Employer Identification Number).
4. Obtain the Necessary Business Permits and Licenses
Depending on the specific nature of your business, you may be required to get one or more licenses or permits from the state or local government. The most common requirement is the Resale License (also called a Sellers Permit or Resale Permit). You might also need a general business operation license, health department permit, or zoning or home-based business permit.
5. Open a Business Bank Account
Once you have registered your business and obtained an EIN, you can open a business bank account and accept checks made out to your business name. In addition, a business bank account keeps your personal and business finances separate – a must for Corporations and LLCs.
Test the Waters
It’s exhilarating when you realize that you can turn your favorite hobby into a commercial venture. A smart idea is to test the waters first by starting your new business on a part-time basis. Just remember that whether you are working on the venture part-time or full-time, you need to take the management and administrative tasks seriously if you want the IRS to consider it a business.
Hobby Photo via Shutterstock